Heartburn in the markets, but is relief coming?

After 6 hours and 34 minutes of testimony before the Commodity Futures and Trading Commission, U.S. agriculture isn’t any closer to solving problems that surfaced in the commodity markets in early March, when extreme price volatility nearly paralyzed forward contracting of crops.

Walter Lukken, acting chairman of the CFTC did announce that the Commission has decided to delay action on proposals to raise the speculative limits for certain agricultural commodities, at least until there is a better understanding of what’s behind the market turmoil.

From January until mid-April, futures prices for wheat, corn, soybeans and rice hit all-time highs. The price of rice increased by 118 percent, wheat by 95 percent, soybeans by 88 percent, corn by 66 percent, and cotton by 47 percent.

Normally, this would be cause for celebration among commodity producers. But the highly volatile market led to runaway margin calls, which snapped credit limits for hedgers and in some cases put them out of business. Bids disappeared at a time when producers desperately needed to lock in high prices to combat rising production costs.

These problems led to the April 22 meeting where commodity exchanges, USDA officials and representatives from almost every agricultural organization crowded into a meeting room at CFTC’s Washington D.C. headquarters.

Memphis cotton merchant William Dunavant cited the events of March 3, 2008, as evidence of a broken cotton market. On that day, “cotton traded from 84.95 cents per pound synthetically to a $1.09. That made no sense.

“If you translate what happened in the futures market that day, it was like the Dow Jones going from 12,000 to 15,500 in one day, a 3,500 point move. That will never happen, but it gives you some idea of how dramatic cotton’s problems are. The market is out of whack and somebody has to step in and give it some relief.

“The cotton producer is being penalized, cotton cooperatives are being penalized. We need to function as a futures market with some stability. We certainly don’t have it now. Traders and commercial hedgers need to be treated on a totally different basis than speculators and commodity funds.”

“Overnight, we have been stripped of a vital tool in which to conduct our business,” said Joe Nicosia, CEO, Allenberg Cotton Co., and incoming president of the American Cotton Shippers Association. “We are now exposed to greater risk, which allows only the few highly financed or leveraged companies to function.”

Nicosia said as a result of the early March upheaval, “the commercial trade had to close out futures at huge losses to generate the cash to repay its loans. Some smaller merchants, who could not withstand these losses, were forced to discontinue operations. Larger merchants with more substantial balance sheets were severely impacted as well and in some cases had to cease or greatly reduce the scope of their operations. At the end of the day, over $1 billion would be posted in margin calls.”

Nicosia pins most of the blame “on the advent of index funds, with an estimated aggregate value of $1 trillion, and the participation of over-the-counter traders, which take a myriad of forms. While bringing record liquidity to the agricultural contracts, these entities have turned these contracts into investment contracts, thereby defeating the purposes for which agricultural contracts were created.

“The result has rendered the agricultural contracts, particularly the cotton contract, ineffective for hedging against price risks, the discovery of prices, and the actual pricing of commercial transactions.”

In response to a question from CFTC Commissioner Walter Dunn on what happened in the cotton market, Nicosia said, “The problem was that (the CFTC) doesn’t have the information to determine what went wrong. So much is taking place off the exchange. Fundamentally what took place was a systematic approach to push prices higher. You saw larger volume and larger price prices that ever existed in night sessions while the industry slept.

“You should ask for all the (funds) to put forth their swap and/or cash activities to see if there is a reason for them to have those sizable positions.”

Woods Eastland, CEO of Staplcotn, and director of AMCOT, which represents the nation’s four major cotton cooperatives, said unwarranted price changes in the markets “are defined in the (Commodity Futures Trading Commission Act) as an undue burden on interstate commerce, which puts the burden on ICE (Intercontinental Exchange) and CFTC to make sure that it doesn’t happen again.

“The consensus here is that something happened in the cotton industry that is not understood. I urge the CFTC to investigate in depth what went on in cotton. If it happens once, it very well could happen again, or it could happen again in some other market.”

Alan Underwood, Underwood Cotton Co., Lubbock, Texas, says the move to an all-electronic trading platform has significantly changed the behavior of the markets.

“Anyone trading the futures market recently should be able to testify to the strange and rhythmic flow of the current market – floating up and down, quickly making price swings in minutes that used to take months. It is no longer driven by supply and demand, but by computer programs chasing each other in an endless computer game where traditional hedgers are nothing more than cannon fodder subject to unfair trade practices never before seen in this magnitude.”

The grain markets suffered from the same problem as the cotton markets, noted Diana Klemme, with the Grain Service Corporation. “If we distill everything down to one issue it has to do with the ability to finance these markets. There would be new crop bids and 2009 crop bids aplenty in every commodity if the elevators, grain companies and everybody else up and down the chain could feel confident that they could meet their margin calls.

“But if you don’t have the credit lines or you’re afraid the credit line won’t be there, you don’t dare go down that road. Then the bids disappear. The farmers are at a disadvantage because their input costs and land costs go up and they can’t market cash grain.”

Tom Buis, president of the National Farmers Union, said, “We began raising concerns in March after hearing from a number of producers who were being shut out of forward contracting their grain by local elevators and co-ops that had exceeded their credit limits to meet margin calls.

“Input costs have tripled over the last two years. If a farmer cannot forward price these commodities at higher prices, we got a train wreck coming that’s going to be greater than any we’ve ever seen.

“For those who say that everything is working right, I’m sorry, maybe I’m wasting my time here, but there are problems out there and it is incumbent upon us all to address them.”

John Popp, with the Independent Bakers Association, says “removing 22 million acres from the food supply and putting it into fuel supply,” is a big part of the problem. “We’re not faced with the surplus problems of year’s past. We now have a limited supply (of commodities) and we have a lot of dollars chasing a tight supply. It’s time to take some of that Conservation Reserve Land and put it back into production. We’re going to need more supply of tillable land.”

Undersecretary of Agriculture Mark Keenum said USDA’s commodity loan programs have not experienced any negative effects – yet. “Because of high market prices, the adjusted world price for cotton, rice, grains and oilseeds are significantly above the loan rates. However, if market prices collapse, there could be significant impacts on program activity and government expenditures.”

Index and commodity fund managers said their activity in the commodity markets is being unfairly portrayed. Bob Greer, with PIMCO, which manages an index-based commodity fund, noted that a long-only investment such as the PIMCO fund, “is assuming some price risk that producers and other interests in the commodity business would like to shed themselves of. There are now over 200,000 individual investors in this country who are offering to do exactly that.

“I don’t think we can measure it, but they have reduced by their collective efforts the amount of risk premium that the commodity producer must pay as they mitigate their risk in these markets.”

Charles Carey, with the CME GROUP, which operates the Chicago Board of Trade, acknowledged that the marketplace “is in a tough spot, particularly with the traditional risk managers, the elevators, the processors, the people who take on the inventory and are the short hedgers.

“One thing that we’re going to have to put on the table is innovation.

Whether this is a shifting paradigm, or a one-time aberration, we’re going to require more and better products to meet the needs of the marketplace. If we continue to innovate, we’ll go a long way toward meeting the needs of the marketplace.”

CFTC Commissioner Michael Dunn said the CFTC would look at suggestions offered at the forum, but finding answers won’t be easy. “There is not a silver bullet or single solution to address the problems we are currently facing.”

Lukken noted, “During such turbulent times, it is tempting to shoot first and ask questions later. But it is exactly at such moments that government must endeavor to be informed and proportional in its response. It is critical that we understand the problem fully so we can get it right and ensure that the cure is not worse than the disease.”

The CFTC, which regulates futures contracts for agricultural commodities, was created in 1974 with the enactment of the Commodity Futures Trading Commission Act.